Relevant cost concepts

Decision making involves making a choice between two or more alternatives.

The decision will be ‘rational’; profit maximising.

All decisions will be made using relevant costs and revenues.

DEFINITION;
‘Relevant costs are future cash flows arising as a direct
consequence of the decision under consideration.’

1
Opportunity Cost
An opportunity cost is the value of the best alternative that is foregone when a
particular course of action is undertaken.

It emphasises that decisions are concerned with choices and that by choosing
one plan there may well be sacrifices elsewhere in the business.

Example 1 – OPPORTUNITY COST

A company which manufactures and sells one single product is currently
operating at 85% of full capacity, producing 102,000 units per month. The
current total monthly costs of production amount to $330,000, of which
$75,000 are fixed and are expected to remain unchanged for all levels of
activity up to full capacity.
A new potential customer has expressed interest in taking regular monthly
delivery of 12,000 units at a price of $2.80 per unit.
All existing production is sold each month at a price of $3.25 per unit. If the
new business is accepted, existing sales are expected to fall by 2 units for
every 15 units sold to the new customer.

What is the overall increase in monthly profit which would result from
accepting the new business?

2
The relevant cost of labour
If labour hours are required to carry out a piece of work, the relevant cost of
their time will depend upon the circumstances. There are generally 3
situations that arise;

 There is spare capacity and the salaried staff are

paid anyway.
o Relevant cost is zero

 The staff are working to their contracted hours, but

additional hours can be obtained, for example
overtime or by hiring additional staff.
o Relevant cost is the direct labour cost

 Staff are fully utilised on existing work, and no

additional hours can be obtained
o Relevant cost is the direct labour cost PLUS
contribution foregone

Always remember to apply basic logic, consider relevant cash flows and
then use a bit of common sense!

3
Example 2 – RELEVANT COST OF LABOUR

100 hours of skilled labour are needed for a special contract.

The staff are working at full capacity at the moment and the workers would
have to be taken off production of Product Y in order to work on the special
contract. No additional labour hours can be obtained and staff will not work
overtime.
The details of the other product are shown below:
$/unit

Selling price 60
Direct material (10)
Direct labour 1 hour @ $10/hour (10)
Variable overheads (15)

Contribution per unit 25

The skilled workers’ pay rate would not change, regardless of which product
they worked on.

What is the relevant cost of labour if the special contract is undertaken?

4
Example 3 – CONTRIBUTION PER HOUR

100 hours of skilled labour are needed for a special contract.

The staff are working at full capacity at the moment and the workers would
have to be taken off production of Product Z in order to work on the special
contract. No additional labour hours can be obtained and staff will not work
overtime.

Product Z generates a contribution of $80 per unit and requires 2 labour

hours per unit. The labour rate is $15 per hour.

The skilled workers’ pay rate would not change, regardless of which product
they worked on.

What is the relevant cost of labour if the special contract is undertaken?

5
Make or Buy decision
Businesses may be faced with the decision whether to make a basic
component for themselves or whether to obtain the component from outside
suppliers.

When evaluating this type of decision simply compare the relevant cost of
buying in the component with the cost of manufacturing the component in-
house.

If the component is to be made in-house, consider carefully the relevant cost

of the resources that are required;
- Look for incremental (marginal) cash flows arising as a direct
consequence of this decision
- If scarce resources are to be used on making the component, watch out
for any opportunity costs

6
Example 4 – RELEVANT COST OF AN ORDER

A company manufactures two models of a pocket calculator; the BASIC model

sells for $5.50, has a direct material cost of $1.25 and requires 0.25 hours of
labour time to produce. The other model, the SCIENTIST, sells for $7.50, has a
direct material cost of $1.65 and takes 0.375 hours to produce.

Labour, which is paid at the rate of $6 per hour, is currently very scarce,
whilst demand for the company’s calculators is heavy. The company is
currently producing 8,000 of the basic model and 4,000 of the scientist model
per month.

An overseas customer has offered the company a contract, worth $35,000, for
a number of calculators made to its requirements. The estimating department
has ascertained the following facts in respect of the work:

 The labour time for the contract would be 1,200 hours.

 The material cost would be $9,000 plus the cost of a particular
component not normally used in the company’s models.
 These components could be purchased from a supplier for $2,500 or,
alternatively, they could be made internally for a material cost of $1,000
and an additional labour time of 150 hours.

Required;
Advise the management on the action they should take.